How a Libor scheme works and what it means to consumers - Boston Globe

The newest scandal to hit the financial industry is the alleged scheme by major international banks to rig one of the most widely used benchmarks, the London interbank offered rate, or Libor as it is commonly called. Libor is used to set interest rates and other terms on more than $900 trillion of financial instruments, from sophisticated investment contracts to home mortgages that have adjustable interest rates.

Last week British banking giant Barclays agreed to pay US and British regulators $453 million to settle charges that it tried to manipulate Libor rates, and authorities in multiple countries are investigating whether other banks that participate in setting Libor tried to rig rates.

Here's a look at how Libor works and how it affects investors and consumers:

Q. What is Libor anyway?

A. The Libor is the published average of interest rates that big banks charge each other to borrow money for periods anywhere from one day to one year. Around 18 large banks, including Barclays, participate in a survey compiled by the British Bankers' Association. Many other lenders, from credit card companies to mortgage providers, then use Libor as a benchmark to determine what rate to charge to lend their money.

Q. Libor sounds like it's for big banks. Why should I care if the rate is wrong?

A. Basically Libor measures the wholesale price for money, and is so broadly used within the lending world that it essentially determines what the retail cost of borrowing, for credit cards mortgages for example, will be. Many types of business lines of credit are based on the published Libor rates.

Libor also affects consumers in many ways, from credit card rates, to student loans with adjustable interest rates, to home mortgages. For instance, 90 percent of subprime mortgages that had adjustable interest rates used Libor to set rates, according to a 2009 study by the Federal Reserve Bank of Cleveland. The researchers also found that 45 percent of "prime" ARMs — that is, those given to people with good credit — had loan rates derived from Libor.

Q. So how could I have been hurt by rigged rates?

A. Libor is also used to set interest rates in many investment products, so millions of investors, taxpayers, and pension-funds participants could have lost money because they got artificially low returns. For example, the brokerage giant Charles Schwab sued 11 major banks, saying they were "surreptitiously bilking investors of their rightful rates of return on their investments."

The city of Baltimore also sued, alleging taxpayers lost money on Libor-based products that the local government bought to protect its municipal bond issues.

Professor Andrew Lo of the Massachusetts Institute of Technology's Sloan School of Management said the scandal could have far-reaching effects since Libor influences so much of the global financial system. Even skewing rates by a tiny amount — 0.01 point — Lo said, would translate into a $90 billion error. "That kind of money dwarfs all of the financial scams in history," Lo said.

Also, Lo worried that the scandal will ultimately make it harder — or more expensive — for consumers and businesses to borrow money because banks might tighten lending as a result of market manipulation.

"A decrease in the trust in the financial system would reduce the amount of money that lenders are willing to give borrowers," Lo said.

Q. What was Barclays accused of doing wrong?

A. Regulators said that the bank sometimes gave the British Banking group false information on what it expected to pay for interbank loans, shaving 0.01 percentage points off the correct figures. The bank skewed the data to boost profits or cut losses on some investments linked to various Libor rates, they said.

Investigators also said that top Barclays management ordered staffers to report lower rates between 2007 and 2009 because its actual costs were higher than what other banks disclosed paying for loans. They feared it would make Barclays look shaky during the global financial crisis. Barclay officials have said they suspected other banks were reporting false Libor rates.

Q. But if the banks reported lower rates, doesn't that mean I paid less in borrowing costs if my mortgage or other loan was based on Libor?

A. In theory, maybe. Barclays is not accused of reporting false information all the time, and when it did, it apparently skewed rates by a tiny bit — so it could be very hard to determine how much that worked out on a typical adjustable mortgage. But Mark Mark Schweitzer, coauthor of the Cleveland Fed's 2009 report, noted that it was possible: "If the result [of Barclays' action] was that the market was quoting a lower Libor rate than it should have, ARM borrowers would actually have been the beneficiaries if they happened to have their rates adjusted on that day," Schweitzer said.

But Greg McBride of mortgage-rate tracker Bankrate.com noted the system is set up to minimize the power any one institution could have in setting rates because the British banking group throws out the top 25 percent and bottom 25 percent of survey results when compiling Libor.

"The likelihood that one bank could have any material influence on the Libor is very, very slim," he said.